Monday, 5 October 2015

Discounted Cash Flow ~ An Overview

DCF short for discounted cash flow analysis is a way to
evaluate a company, project or assets. Cash flows for the future are assumed
and discounted considering cost of capital to get the current values. Sum of
future cash flows outgoing or incoming is net present value (NPV) that’s taken
as price or value of cash flows. Discounted cash flow analysis is used to
determine the worth of an investment in simplified terms. It is used in real
estate development, investment finance, patent evaluation and corporate
financial management.

As Matthew Roddan
from Project Ninety Nine says,
understanding the probability of risk and profits is very important in an
investment decision. Investment decisions are made for profits and
understanding what one can expect is very important to determine the
suitability of an investment. Exponential discounting is the most common method
deployed for discounting, to evaluate future cash flows answering the question
– what would be the returns for an investment at a specific rate of return, as
against cash flow expected in the future? Hyperbolic discounting is another
method, though not deployed widely. Discount rate is the right weighted average
cost of capital (WACC) and it reflects cash flow risks.

Discounted cash flow analysis is important for any investor
to determine if or not an investment decision is suitable. Let’s look at it
this way – consider the investment as a business or a company. DCF is a way to
determine a company worth currently, based on calculations for the future.
Though this is a useful method, it does have hiccups. Being a mechanical
evaluation tool, it is bond by a principle and even simple changes in one value
could result in major changes in value. So, instead of determining values for infinity
a cap is used – say 10 years. This way, estimation becomes measurable.

Besides, Discounted Cash Flow is a method that uses
intrinsic valuation for companies that have predictable flow of cash. It is
used for companies that have been around for a while, though it is also used
for IT companies that are expected to grow swiftly. This means, when a start-up
or developing firm is evaluated, the results could go right or horribly wrong!
As an investor, you must be able to weigh your options and prepare for both,
says Matthew Roddan of Project Ninety Nine. This way or that,
evaluating an investment is important for any investor and determining the
right investments is done based on calculations that are probabilities and possibilities,
not a definitive. The calculated risk should be something you would be able to
manage, irrespective of whether it turns our favorable or not!